Chapter 4

Individual and Market Demand

Topics to be Discussed
Individual Demand
Income and Substitution Effects
Market Demand
Consumer Surplus

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Chapter 4

Individual Demand
Price Changes
Using

the figures developed in the previous

chapter, the impact of a change in the price
of food can be illustrated using indifference
curves.
For each price change, we can determine
how much of the good the individual would
purchase given their budget lines and
indifference curves

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Chapter 4

Effect of a Price Change

Clothing

Assume:
I = $20
PC = $2
PF = $2, $1, $0.50

10

U1

Each price leads to

different amounts of
food purchased

D
B

U3

U2

4
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Chapter 4

Food (units
per month)
4

Effect of a Price Change

Clothing

The PriceConsumption Curve

traces out the utility
maximizing market
basket for each price
of food

10

U1

D
B

U3

U2

4
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Chapter 4

Food (units
per month)
5

Effect of a Price Change

By changing prices
and showing what
the consumer will
purchase, we can
create a demand
schedule and
demand curve for the
individual
From the previous
example:
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Chapter 4

Demand Schedule
P

$2.00

20

$1.00

12

$0.50

Effect of a Price Change

Price
of Food
Individual Demand relates
the quantity of a good that
a consumer will buy to the
price of that good.

$2.00

$1.00

Demand Curve
$.50

H
4

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Chapter 4

Food (units
per month)
7

Demand Curves Important

Properties
The level of utility that can be attained
changes as we move along the curve.
At every point on the demand curve, the
consumer is maximizing utility by
satisfying the condition that the MRS of
food for clothing equals the ratio of the
prices of food and clothing.

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Chapter 4

Effect of a Price Change

Price
of Food

When the price falls:

Pf/Pc & MRS also fall

$2.00

E: Pf/Pc = 2/2 = 1 = MRS

G: Pf/Pc = 1/2 = .5 = MRS
H:Pf/Pc = .5/2 = .25 = MRS

$1.00
$.50

H
4

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Demand Curve

20
Chapter 4

Food (units
per month)
9

Individual Demand
Income Changes
Using the figures developed in the previous
chapter, the impact of a change in the
income can be illustrated using indifference
curves.
Changing income, with prices fixed, causes
consumer to change their market baskets.

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Chapter 4

10

Effects of Income Changes

Clothing
(units per
month)

Assume: Pf = $1, Pc = $2
I = $10, $20, $30

U3

An increase in income,
with the prices fixed,
causes consumers to alter
their choice of
market basket.

U2
B

U1

4
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Chapter 4

Food (units
per month)
11

Individual Demand
Income Changes
The income-consumption curve traces out
the utility-maximizing combinations of food
and clothing associated with every income
level.

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Chapter 4

12

Individual Demand
Income Changes
An

increase in income shifts the budget line

to the right, increasing consumption along
the income-consumption curve.
Simultaneously, the increase in income shifts
the demand curve to the right.

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Chapter 4

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Effects of Income Changes

Clothing
(units per
month)

The Income Consumption

Curve traces out the utility
maximizing market basket
for each income level

U3

Income Consumption
Curve

U2
B

U1

4
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Chapter 4

Food (units
per month)
14

Effects of Income Changes

Price
of
food

An increase in income, from

$10 to $20 to $30, with the
prices fixed, shifts the
consumers demand curve
to the right as well.

$1.00

D3
D2
D1

4
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Chapter 4

Food (units
per month)
15

Individual Demand
Income Changes
When the income-consumption curve has a
positive slope:
The

quantity demanded increases with income.

The income elasticity of demand is positive.
The good is a normal good.

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Individual Demand
Income Changes
When the income-consumption curve has a
negative slope:
The

quantity demanded decreases with income.

The income elasticity of demand is negative.
The good is an inferior good.

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An Inferior Good
Steak
(units per
month)

Both hamburger
and steak behave
as a normal good,
between A and B...

Income-Consumption
Curve
C

10
U3

but hamburger
becomes an inferior
good when the income
consumption curve
bends backward
between B and C.

U2

A
U1

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Chapter 4

30

Hamburger
(units per month)
18

Individual Demand
Engel Curves
Engel

curves relate the quantity of good

consumed to income.
If the good is a normal good, the Engel curve
is upward sloping.
If the good is an inferior good, the Engel
curve is downward sloping.

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Engel Curves
Income 30
($ per
month)
Engel curves slope
upward for
normal goods.

20

10

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Chapter 4

16

Food (units
per month)
20

Engel Curves
Income 30
($ per
month)

Inferior
Engel curves are
backward bending
for inferior goods.

20
Normal
10

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Chapter 4

16

Food (units
per month)
21

Substitutes & Complements

Two goods are considered substitutes if
an increase (decrease) in the price of
one leads to an increase (decrease) in
the quantity demanded of the other.
Ex: movie tickets and video rentals

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Substitutes & Complements

Two goods are considered complements
if an increase (decrease) in the price of
one leads to a decrease (increase) in the
quantity demanded of the other.
Ex: gasoline and motor oil

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Substitutes & Complements

Two goods are independent then a
change in the price of one good has no
effect on the quantity demanded of the
other
Ex: chicken and airplane tickets

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Substitutes & Complements

If the price consumption curve is
downward-sloping, the two goods are
considered substitutes.
If the price consumption curve is upwardsloping, the two goods are considered
complements.
They could be both.

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Income and Substitution Effects

A change in the price of a good has two
effects:
Substitution Effect
Income Effect

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Income and Substitution Effects

Substitution Effect
Relative price of a good changes when price
changes
Consumers will tend to buy more of the good
that has become relatively cheaper, and less
of the good that is relatively more expensive.

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Income and Substitution Effects

Income Effect
Consumers experience an increase in real
purchasing power when the price of one
good falls.

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Income and Substitution Effects

Substitution Effect
The substitution effect is the change in an
items consumption associated with a change
in the price of the item, with the level of
utility held constant.
When the price of an item declines, the
substitution effect always leads to an
increase in the quantity demanded of the
good.

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Income and Substitution Effects

Income Effect
The income effect is the change in an items
consumption brought about by the increase
in purchasing power, with the price of the
item held constant.
When a persons income increases, the
quantity demanded for the product may
increase or decrease.

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Income and Substitution Effects

Income Effect
Even with inferior goods, the income effect is
rarely large enough to outweigh the
substitution effect.

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Income and Substitution

Effects: Normal Good
Clothing
(units per
month) R

When the price of food falls,

consumption increases by F1F2
as the consumer moves from A
to B.
The substitution effect,F1E,
(from point A to D), changes the
A
relative prices but keeps real income
(satisfaction) constant.

C1

C2

U2

Substitution
Effect

F1

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Total Effect

The income effect, EF2,

( from D to B) keeps relative
prices constant but
increases purchasing power.

U1
E

Chapter 4

F2

Income Effect

Food (units
per month)
32

Income and Substitution

Effects: Inferior Good
Clothing
(units per
month) R

Since food is an
inferior good, the
income effect is
negative. However,
the substitution effect
is larger than the
income effect.

A
B

U2

Substitution
Effect

F1

Total Effect
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U1
E

F2

Chapter
4
Income
Effect

Food (units
per month)

33

Income and Substitution Effects

A Special Case--The Giffen Good
The income effect may theoretically be large
enough to cause the demand curve for a
good to slope upward.
This rarely occurs and is of little practical
interest.

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Chapter 4

34

Market Demand
Market Demand Curves
A curve that relates the quantity of a good
that all consumers in a market buy to the
price of that good.
The sum of all the individual demand curves
in the market

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Determining the Market Demand

Curve
Price

Market
Demand

10

16

32

13

25

10

18

11

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Summing to Obtain a
Market Demand Curve
Price

The market demand

curve is obtained by
summing the consumers
demand curves

4
3

Market Demand
2
1
0

DA
5

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DB
10

DC
15
Chapter 4

20

25

30

Quantity
37

Market Demand
Price Elasticity of Demand
Measures the percentage change in the
quantity demanded resulting from a percent
change in price.

% Q Q/Q Q P
EP

% P P/P P Q
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Price Elasticity of Demand

Inelastic Demand
Ep is less than 1 in absolute value
Quantity demanded is relative unresponsive
to a change in price
%Q < %P
Total expenditure (P*Q) increases when price
increases

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Price Elasticity of Demand

Elastic Demand
Ep is greater than than 1 in absolute value
Quantity demanded is relative responsive to
a change in price
%Q > %P
Total expenditure (P*Q) decreases when
price increases

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Price Elasticity and

Consumer Expenditure

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Consumer Surplus
Consumers buy goods because it makes
them better off
Consumer Surplus measures how much
better off they are

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Consumer Surplus
Consumer Surplus
The difference between the maximum
amount a consumer is willing to pay for a
good and the amount actually paid.
Can calculate consumer surplus from the
demand curve

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Consumer Surplus - Example

Student wants to buy concert tickets
Demand curve tells us willingness to pay
for each concert ticket
1st ticket worth $20 but price is $14 so
student generates $6 worth of surplus
Can measure this for each ticket
Total surplus is addition of surplus for each
ticket purchased

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Consumer Surplus - Example

Price
($ per
ticket)

The consumer surplus

of purchasing 6 concert
tickets is the sum of the
surplus derived from
each one individually.

20
19
18
17
16

Consumer Surplus
6 + 5 + 4 + 3 + 2 + 1 =

15
14

21

13

Market Price

Will not buy more than 7

because surplus is
negative

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Chapter 4

Rock Concert Tickets

45

Consumer Surplus
The stepladder demand curve can be
converted into a straight-line demand
curve by making the units of the good
smaller.
Consumer surplus is area under the
demand curve and above the price

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Consumer Surplus
Price
($ per
ticket)

13

Consumer Surplus
for the Market Demand
20
19
18
17
16
15
14

CS = ($20 - $14)*(6000)
= $36,000
Consumer
Surplus
Market Price
Demand Curve
Actual
Expenditure

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Chapter 4

Rock Concert Tickets(000)

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